Quarterly Investment Strategy
THE US ECONOMY (READ: CONSUMER) STILL HAS STAMINA
In a nutshell:
- 2016 should not be the year in which the US economy falls into recession.
- The Fed has signalled greater near-term tolerance for inflation, bringing its 2016 rate hike projections closer to market expectations.
- That said, its progressive tightening cycle remains on track, alongside gradually rising core inflation and further strengthening of the labour market.
We suspect that the slowdown experienced in the 4th quarter of 2015 will prove to be yet another blip in the ongoing US cycle – clearly now at a mature stage but not set to end this year.
Industrial production remains the weak link in the US economy, although the recent oil price recovery has brought about early signs of improvement. In other areas, be they real business sales, employment, real income or consumer confidence/spending, the picture continues to look very solid.
That said, the very fact that consumers have been carrying a mighty load during this long expansion is beginning to generate some underlying price pressures. February saw core CPI (consumer price index) growth reach 2.3% year-on-year, its highest level since September 2008. This measure of inflation ex-food and energy has been grinding higher since its December 2014 trough, with the core PCE (personal consumption expenditures) price index, which the Fed actually prefers, following in its footsteps. Other gauges of underlying inflation pressures that we monitor also show similar upward trends (core CPI ex-shelter, CPI services ex-energy, median CPI, trimmed-mean PCE).
For now, as indicated by US Federal Reserve (Fed) Chair Janet Yellen during a recent conference, US monetary authorities are downplaying the pickup in core price indexes. This apparently greater tolerance for inflation in the near term has closed the gap between Fed and market expectations of rate increases during 2016. Both now anticipate only a couple of hikes, the first of which could occur in June 2016 – assuming core prices continue to rise and labour markets to tighten.
Beyond 2016, the divergence between the Fed- and market-expected trajectories for US short term rates remains pronounced, in terms of both the pace of tightening and the terminal value of Fed funds. Ultimately this economic cycle should be no different to most prior ones. The Fed will eventually kill it by flattening (or even inverting) the yield curve and reducing the incentive for commercial banks to grant loans to the real economy.
Such fears do, however, seem premature. The yield curve is still steep, allowing for a healthy progression in money aggregates and, most importantly, an above-8% rate of growth in bank loans – with all major loan categories experiencing an acceleration. Frankly speaking, it is difficult to see the US domestic economy weaken markedly in the near future.
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